978-1259277160 Chapter 11 Solution Manual Part 4

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11-28. Solution:

Nolan Corporation

a. Cost

(aftertax) Weights

Weighted

Cost

Retained earnings

b. % of retained earnings within the capital structure

$18 million $90 million

.20

= =

11-28. (Continued)

c. Cost

(aftertax) Weights

Weighted

Cost

Amount of lower cost debt

d. % of debt within the capital structure

$29 million $58 million

.50

= =

e. Cost

(aftertax) Weights

Weighted

Cost

29. Marginal cost of capital (LO11-5) The McGee Corporation finds it is necessary to

determine its marginal cost of capital. McGee’s current capital structure calls for 40 percent

debt, 30 percent preferred stock, and 30 percent common equity. Initially, common equity

will be in the form of retained earnings (Ke) and then new common stock (Kn). The costs of

the various sources of financing are as follows: debt, 9.6 percent; preferred stock, 9.0

percent; retained earnings, 10.0 percent; and new common stock, 11.4 percent.

a. What is the initial weighted average cost of capital? (Include debt, preferred stock, and

common equity in the form of retained earnings, Ke.)

b. If the firm has $28.5 million in retained earnings, at what size capital structure will the

firm run out of retained earnings?

c. What will the marginal cost of capital be immediately after that point? (Equity will

remain at 30 percent of the capital structure, but will all be in the form of new

common stock, Kn.)

d. The 9.6 percent cost of debt referred to earlier applies only to the first $30 million of

debt. After that, the cost of debt will be 11.2 percent. At what size capital structure will

there be a change in the cost of debt?

e. What will the marginal cost of capital be immediately after that point? (Consider the

facts in both parts c and d.)

11-29. Solution:

The McGee Corporation

a. Cost

(aftertax) Weights

Weighted

Cost

of McGraw-Hill Education.

Retained earnings

% of retained earnings within the capital structure

$28.5 million $95 million

.30

= =

11-29. (Continued)

c. Cost

(aftertax) Weights

Weighted

Cost

Amount of lower cost debt

% of debt within the capital structure

$30 million $75 million

.40

= =

e. Cost

(aftertax) Weights

Weighted

Cost

of McGraw-Hill Education.

30. Capital asset pricing model and dividend valuation model (LO11-3) Eaton Electronic

Company’s treasurer uses both the capital asset pricing model and the dividend valuation

model to compute the cost of common equity (also referred to as the required rate of return

for common equity).

Assume:

Rf= 7%

Km= 10%

β = 1.6

D1= $.70

P0= $19

g= 8%

a. Compute Ki (required rate of return on common equity based on the capital asset

pricing model).

b. Compute Ke (required rate of return on common equity based on the dividend

valuation model).

11-30. Solution:

Eaton Electronic Company

of McGraw-Hill Education.

$.70

= 8%

$19

3.68% 8% 11.68%

K g

= +

= + =

Although the values are equal in this example, that is not always

the case.

COMPREHENSIVE PROBLEM

Comprehensive Problem 1

Medical Research Corporation is expanding its research and production capacity to introduce a

new line of products. Current plans call for the expenditure of $100 million on four projects of

equal size ($25 million each), but different returns. Project A is in blood clotting proteins and has an

expected return of 18 percent. Project B relates to a hepatitis vaccine and carries a potential return of

14 percent. Project C, dealing with a cardiovascular compound, is expected to earn 11.8 percent, and

Project D, an investment in orthopedic implants, is expected to show a 10.9 percent return.

The firm has $15 million in retained earnings. After a capital structure with $15 million in

retained earnings is reached (in which retained earnings represent 60 percent of the financing),

all additional equity financing must come in the form of new common stock.

Common stock is selling for $25 per share and underwriting costs are estimated at $3 if new

shares are issued. Dividends for the next year will be $.90 per share (D1), and earnings and

dividends have grown consistently at 11 percent per year.

The yield on comparative bonds has been hovering at 11 percent. The investment banker

feels that the first $20 million of bonds could be sold to yield 11 percent while additional debt

might require a 2 percent premium and be sold to yield 13 percent. The corporate tax rate is 30

percent. Debt represents 40 percent of the capital structure.

a. Based on the two sources of financing, what is the initial weighted average cost of capital?

(Use Kd and Ke.)

b. At what size capital structure will the firm run out of retained earnings?

c. What will the marginal cost of capital be immediately after that point?

d. At what size capital structure will there be a change in the cost of debt?

e. What will the marginal cost of capital be immediately after that point?

f. Based on the information about potential returns on investments in the first paragraph and

information on marginal cost of capital (in parts a, c, and e), how large a capital investment

budget should the firm use?

g. Graph the answer determined in part f.

of McGraw-Hill Education.

Medical Research Corporation

a. Kd = Yield (1 – T)

Ke = (D1/P0) + g

Cost

(aftertax) Weights

Weighted

Cost

of capital (Ka)………………

Retained earnings

% of retained earnings in the capital structure

$15 million $25 million

.60

= =

c. First compute Kn

Cost

(aftertax) Weights

Weighted

Cost

(Kmc)…………………………..

Amount of lower cost debt

% of debt in the capital structure

$20 million $50 million

.40

= =

e. First compute the new value for Kd.

Cost

(aftertax) Weights

Weighted

Cost

(Kmc)…………………………..

f. The answer is $50 million.

Return on

Investment

Marginal Cost

of Capital

CP 11-1. (Continued)

g. The top bar represents return on investment.

Percent (return)

18%

0 25 50 75 100

Amount of Capital ($ millions)

Comprehensive Problem 2

Masco Oil and Gas Company is a very large company with common stock listed on the New

York Stock Exchange and bonds traded over the counter. As of the current balance sheet, it has

three bond issues outstanding:

$150 million of 10 percent series………………….. 2021

$50 million of 7 percent series……………………… 2015

$75 million of 5 percent series……………………… 2011

The vice president of finance is planning to sell $75 million of bonds next year to replace the

debt due to expire in 2011. Present market yields on similar Baa-rated bonds are 12.1 percent.

Masco also has $90 million of 7.5 percent noncallable preferred stock outstanding, and it has no

intentions of selling any preferred stock at any time in the future. The preferred stock is currently

priced at $80 per share, and its dividend per share is $7.80.

The company has had very volatile earnings, but its dividends per share have had a very

stable growth rate of 8 percent and this will continue. The expected dividend (D1) is $1.90 per

share, and the common stock is selling for $40 per share. The company’s investment banker has

quoted the following flotation costs to Masco: $2.50 per share for preferred stock and $2.20 per

share for common stock.

of McGraw-Hill Education.

On the advice of its investment banker, Masco has kept its debt at 50 percent of assets and its

equity at 50 percent. Masco sees no need to sell either common or preferred stock in the

foreseeable future as it has generated enough internal funds for its investment needs when these

funds are combined with debt financing. Masco’s corporate tax rate is 40 percent.

Compute the cost of capital for the following:

a. Bond (debt) (Kd).

b. Preferred stock (Kp).

c. Common equity in the form of retained earnings (Ke).

d. New common stock (Kn).

e. Weighted average cost of capital.

CP 11-2. Solution

Masco Oil and Gas Company

a. The before tax cost of debt will be equal to the market

b. The fact that the preferred stock carries a coupon rate of

7.5 percent does not influence Kp, which is dependent

c. Ke = (D1/P0) + g

d. Kn = (D1/P0 – F) + g

CP 11-2. (Continued)

of McGraw-Hill Education.

e. Only those sources of capital that are expected to be used

as long-run optimum components of the capital structure

Cost

(aftertax) Weights

Weighted

Cost

Appendix

11A-1. Assume that Rf = 5 percent and Km = 10.5 percent. Compute Kj for the following betas

using Formula 11A-2.

a. 0.6

b. 1.3

c. 1.9

11A-1 Solution:

a. Kj= Rf + β (Km – Rf)

b. Kj= 5% + 1.3 (10.5% – 5%)

of McGraw-Hill Education.

c. Kj= 5% + 1.9 (10.5% – 5%)

11A-2. Assume that Rf = 6 percent and the market risk premium (Km – Rf) is 7.0 percent.

Compute Kj for the following betas using Formula 11A-2.

a. 0.6

b. 1.3

c. 1.9

11A-2. Solution:

a. Kj = 6% + .6 (7%)

b. Kj= 6% + 1.3 (7%)

c. Kj= 6% + 1.9 (7%)

of McGraw-Hill Education.